Life Insurers Looking for Growth
Despite improved financial strength, we still view the industry unfavorably.
The fourth-quarter earnings reports of the domestic life insurance companies we cover were generally quite solid. This is particularly notable considering the strength of last year's quarter, one in which markets were rallying significantly after lows reached earlier in the year during the financial crisis. As life insurance companies increasingly relied on variable annuities and other spread-based products to drive revenue and profits, their balance sheets became more exposed to equity market fluctuations. This exposure, along with the investments in the companies' portfolios, severely damaged the balance sheets of many life insurance firms. As markets have improved in the last years, results have bounced back and equity ratios have stabilized. Therefore, the year-over-year improvements from many of the life insurance companies is not surprising given the more than 10% increase in the S&P 500 during the quarter.
Most of the life insurers raised equity during the crisis--many at severely dilutive prices--but capital positions are now back to near pre-crisis levels. On an asset-weighted basis (to avoid skewing the results by the relatively small but highly capitalized Torchmark (TMK)), the average equity/assets ratio, excluding separate accounts, now stands at approximately 10%. This is much higher than the single-digit levels reported during the depths of the financial crisis, but it is important to note that life insurance companies continue to exhibit a large amount of leverage. Although some of the companies are attempting to lower the risk of their operations and balance sheet going forward, we believe it will be necessary for life insurers to hold higher capital levels than they had in the past. Over time, this will not only fortify financial strength, but will also put pressure on ROEs.
Despite strong fourth quarters, we estimate that many of the life insurers still generated returns below their cost of capital. Unfavorable industry dynamics cause us to dislike the business models, which is why few life insurers are endowed with a moat, in our view. We believe moats are difficult to achieve across the insurance industry, but life insurers in particular struggle to maintain long-term competitive advantages. Life insurance contracts are very similar to commodities, and consumers are likely to shop for the best price. Any innovation created by industry players can quickly be replicated by competitors, pushing down returns. Finally, irrational players can operate for an extended period of time with delayed consequences years out, forcing the industry to either match artificially low prices or lose business.
There are still a few insurance companies that have been able to establish the long-term competitive advantages necessary to generate a moat. Torchmark, Principal Financial (PFG), and Aflac (AFL) all carry narrow economic moats. Torchmark targets niche distribution channels, including direct sales and a subsidiary dedicated to selling to union members. While many of these channels are small, Torchmark has established itself as the dominant player in these submarkets, and its low-cost advantage helps keep competitors at bay. Principal and Aflac, while classified as life insurers, don't focus on traditional life insurance as much as the rest of the group does. Aflac's products are primarily supplementary insurance, which are more easily priced, allowing the firm to generate a strong underwriting margin. Furthermore, it has a low-cost business model and first-mover advantage in Japan, allowing it to generate excess returns. Principal, on the other hand, has dug itself a moat by being more of an asset manager and retirement product provider. The firm targets small businesses, a niche with lower penetration levels. It is also able to leverage its life insurance products and sell to the executives of these small businesses, keeping customers sticky through a large suite of complimentary services. While none of these companies are currently trading at substantial discounts to our fair value estimates, we think that investors should focus on these firms first if considering an investment in the life insurance industry.
Looking ahead, we believe international operations will drive a large portion of future results for domestic life insurance companies. Most already had international operations, but a few have strengthened their positions through acquisitions. Notably, MetLife (MET), through its acquisition of AIG's (AIG) Alico, and Prudential (PRU), through its acquisition of AIG's Star and Edison Life companies, have enhanced their positions in Asian emerging markets. Compared to mature domestic markets, emerging markets are underpenetrated by insurers. As these emerging countries grow, they increasingly use insurance for risk management purposes, giving life insurance companies new customers. Global expansion has the potential to make life insurers more profitable in the near term as they convert new, previously uninsured, customers as opposed to engaging in costly competition with each other. We expect solid growth and profitability to persist in upcoming quarters, provided the financial markets cooperate.
Drew Woodbury does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.